Question

McCormick & Company is considering a project that requires an initial investment of $24 million to build a new plant and purchase equipment. The investment will be depreciated as a modified accelerated cost recovery system (MACRS) seven-year class asset. The new plant will be built on some of the company's land, which has a current, after-tax market value of $4.3 million.

The company will produce bulk units at a cost of $130 each and will sell them for $420 each. There are annual fixed costs of $500,000. Unit sales are expected to be $150,000 each year for the next six years, at which time the project will be abandoned. At that time, the plant and equipment is expected to be worth $8 million (before tax) and the land is expected to be worth $5.4 million (after tax).

To supplement the production process, the company will need to purchase $1 million worth of inventory. That inventory will be depleted during the final year of the project. The company has $100 million of debt outstanding with a yield to maturity of 8 percent, and has $150 million of equity outstanding with a beta of 0.9. The expected market return is 13 percent, and the risk-free rate is 5 percent. The company's marginal tax rate is 40 percent.

Year	Depreciation Rate
1	14.29%
2	24.49%
3	17.49%
4	12.49%
5	8.93%
6	8.92%
7	8.93%
8	4.46%

Questions

1. What will be the tax depreciation each year?

2. What will be the value of the plant and equipment for tax purposes in year six? Will it be sold for a gain or a loss, and what will the tax effect be?

3. What is the weighted average cost of capital (WACC)?

4. What is the salvage cash flow of the new equipment? Include the income tax effect.

5. What is the total operating cash flows, given the following operating cash flows:

Sales = 150,000 x $420 = $63,000,000

Costs = 150,000 x $130 + $500,000 = $20,000,000

6. Create an after-tax cash flow timeline.

7. What are the total expected cash flows at the end of year six? The $4.3 million is an opportunity cost and must be included at date zero as a cash outflow. If the project is accepted, however, the land can be sold in six years for $5.4 million.

8. Find the NPV using the after-tax WACC as the discount rate.

9. Find the IRR.

10. Should the project be accepted? Discuss whether NPV or IRR creates the best decision rule.

Answer 1

		0	1	2	3	4	5	6
1)	Depreciation %		14.29	24.49	17.49	12.49	8.93	8.92
	Tax depreciation		$      34,29,600	$       58,77,600	$      41,97,600	$     29,97,600	$        21,43,200	$       21,40,800	$ 2,07,86,400
2)	Cost of the plant and equipment							$   2,40,00,000
	Less: Accumulated depreciation							$   2,07,86,400
	Book value at EOY 6							$       32,13,600
	Sale value							$       80,00,000
	Gain							$       47,86,400
	Tax at 40%							$       19,14,560
	After tax salvage value = 8000000-1914560 =							$       60,85,440
3)	After tax cost of debt = 8%*(1-40%) =	4.80%
	Cost of equity per CAPM = 5%+0.9*(13%-5%) =	12.20%
	WACC = 12.20%*150/250+4.80%*100/150 =	10.52%
4)	Salvage cash flow [For calculation see [4] above.							$       60,85,440
5)	Sales		$ 6,30,00,000	$   6,30,00,000	$ 6,30,00,000	$ 6,30,00,000	$    6,30,00,000	$   6,30,00,000
	Variable cost		$ 1,95,00,000	$   1,95,00,000	$ 1,95,00,000	$ 1,95,00,000	$    1,95,00,000	$   1,95,00,000
	Fixed cost		$        5,00,000	$         5,00,000	$        5,00,000	$        5,00,000	$          5,00,000	$         5,00,000
	Depreciation		$      34,29,600	$       58,77,600	$      41,97,600	$     29,97,600	$        21,43,200	$       21,40,800
	NOI		$ 3,95,70,400	$   3,71,22,400	$ 3,88,02,400	$ 4,00,02,400	$    4,08,56,800	$   4,08,59,200
	Tax at 40%		$ 1,58,28,160	$   1,48,48,960	$ 1,55,20,960	$ 1,60,00,960	$    1,63,42,720	$   1,63,43,680
	NOPAT		$ 2,37,42,240	$   2,22,73,440	$ 2,32,81,440	$ 2,40,01,440	$    2,45,14,080	$   2,45,15,520
	Add: Depreciation		$      34,29,600	$       58,77,600	$      41,97,600	$     29,97,600	$        21,43,200	$       21,40,800
	OCF		$ 2,71,71,840	$   2,81,51,040	$ 2,74,79,040	$ 2,69,99,040	$    2,66,57,280	$   2,66,56,320
6)	Initial investment = 24000000+4300000 =	$         2,83,00,000
	Change in NWC	$             10,00,000						$     -10,00,000
	After tax salvage value of plant and equipment							$       60,85,440
	After tax salvage value of land							$       54,00,000
	After tax cash flow	$        -2,93,00,000	$ 2,71,71,840	$   2,81,51,040	$ 2,74,79,040	$ 2,69,99,040	$    2,66,57,280	$   3,91,41,760
7)	Total expected cash flows at EOY 6							$   3,91,41,760
8)	After tax cash flow	$        -2,93,00,000	$ 2,71,71,840	$   2,81,51,040	$ 2,74,79,040	$ 2,69,99,040	$    2,66,57,280	$   3,91,41,760
	PVIF at 10.52% [PVIF = 1/1.1052^n]	1	0.90481	0.81869	0.74076	0.67025	0.60645	0.54872
	PV at 10.52%	$        -2,93,00,000	$ 2,45,85,451	$   2,30,46,909	$ 2,03,55,367	$ 1,80,96,093	$    1,61,66,330	$   2,14,78,062
	NPV	$         9,44,28,212
9)	IRR is that discount rate for which NPV is 0. It has to be arrived at by trial and error
	by varying the discount rate suitabley to get 0 NPV.
	PVIF at 92%	1	0.52083	0.27127	0.14129	0.07359	0.03833	0.01996
	PV at 92%	$        -2,93,00,000	$ 1,41,52,000	$       76,36,458	$      38,82,378	$     19,86,751	$        10,21,668	$         7,81,327
	NPV	$               1,60,583
	PVIF at 93%	1	0.51813	0.26846	0.13910	0.07207	0.03734	0.01935
	PV at 93%	$        -2,93,00,000	$ 1,40,78,674	$       75,57,529	$      38,22,343	$     19,45,894	$          9,95,473	$         7,57,350
	NPV	$              -1,42,739
	IRR = 92%+1%*160583/(160583+142739) =	92.53%
10)	The project should be accepted as the NPV is positive and IRR is greater than WACC.
	NPV is the better measure, as it gives the absolute addition to shareholders' wealth
	if the project is undertaken.